China's Exorbitant Surplus Calls for a Much Stronger Yuan

 

China's Exorbitant Surplus Calls for a Much Stronger Yuan

## Introduction: The $1.2 Trillion Elephant in the Room

Imagine for a moment that you're running a business. Your products are selling faster than you can make them. Your customers are paying you billions more than you're spending. Your bank account is overflowing with cash. And yet, you keep your prices artificially low—so low that you're effectively giving your customers a 30% discount on everything you sell.

Sounds like a terrible business strategy, right? Unless you're trying to put every competitor out of business.

That's the uncomfortable analogy at the heart of one of the most consequential economic debates of 2026. China is running the largest trade surplus in human history—a staggering **$1.2 trillion in 2025 alone**—and it's doing so with a currency that experts say is **30% to 35% undervalued**.

Former U.S. Treasury official Brad Setser, now a senior fellow at the Council on Foreign Relations, has been the most vocal critic of this arrangement. His "China Shock 2.0" thesis has rattled policymakers from Washington to Berlin, and it's forcing a global conversation about whether the world can continue to absorb China's export-driven growth model without pushing back.

"The world should not ignore China's obviously undervalued currency," Setser argues. And he's not alone. Economists including Robin Brooks and Mark Sobel have joined the chorus, warning that China's massive surplus—now roughly **2% of world GDP**—is roughly **twice the largest surplus Japan ever ran** at the peak of its export machine.

So why does this matter to you, an American reader? Because the undervalued yuan isn't just a Chinese problem. It's reshaping global trade, destroying manufacturing jobs in the U.S. and Europe, and creating economic imbalances that could eventually threaten the stability of the entire global financial system.

Let's break down the numbers, the arguments, and the stakes.

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## The Numbers: China's Unprecedented Surplus

### A Surplus Like No Other

Let's start with the raw data, because it's truly eye-opening.

In 2025, China's annual trade surplus hit a record **$1.19 trillion**—up 20% from 2024 and the highest in global history. The country surged into 2026 on red-hot AI-fueled electronics demand, raising expectations it could eclipse last year's record.

The first two months of 2026 alone produced a trade surplus of **$213.62 billion**, far exceeding market expectations of $196.6 billion. In the second quarter of 2026, China's current account surplus widened to **$195.1 billion**—the largest surplus on record for the second quarter. The goods surplus alone reached **$278.9 billion**, up from $219.1 billion in the same period the previous year.

To put these numbers in perspective, Setser points out that China's manufacturing surplus is now roughly **2% of world GDP**—about **twice the largest surplus Japan ever ran** (the target of the 1985 Plaza Accord) and **twice Asia's pre-GFC peak**. As Adam Tooze has noted, this represents "mercantilist-on-mercantilist violence," with China's gains coming partly at the expense of other surplus economies like Germany.

### The Statistical Puzzle

But here's where it gets complicated. China's official current account surplus for 2025 was reported at about **$735 billion**, just over 3% of GDP. Setser puts the real figure closer to **5.5% of GDP**—nearly double the official number.

Why the discrepancy? Setser argues that China's balance of payments data contains **significant statistical puzzles** that understate the true scale of the surplus. He has highlighted how China masks exports through foreign subsidiaries and investments, and questions the official accounting treatment of investment income deficits.

The implications are profound. If Setser is right—and his analysis has been influential enough to shape policy debates in both the U.S. and Europe—then China's currency is even more undervalued than official estimates suggest.

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## The Currency Connection: Why a Weak Yuan Matters

### 30% Undervalued

The yuan is now trading at about **6.78 to the dollar**. But Setser and other economists argue that this exchange rate significantly understates the currency's true value.

Setser says the renminbi is now **30% to 35% undervalued**. Other experts, including former Treasury official Mark Sobel, estimate the undervaluation at **20% to 30%**. Goldman Sachs currency strategist Teresa Alves has called a rise in the value of the yuan in 2026 one of her firm's "highest conviction" views.

Even the famous Big Mac Index—The Economist's lighthearted but surprisingly accurate measure of currency valuation—agrees with Setser's assessment, putting the yuan around 30% undervalued.

### How China Keeps the Yuan Weak

China's currency is not freely floating. It operates under a **managed floating exchange rate system**. The People's Bank of China actively intervenes in currency markets to prevent the yuan from appreciating too quickly.

In February 2026, the PBOC cut the foreign exchange risk reserve ratio for forward forex sales from 20% to zero—a move explicitly designed to "curb one-way, excessive yuan appreciation". The central bank has also raised the macro-prudential adjustment coefficient for overseas lending by Chinese firms, allowing more capital to flow out of the country and reducing upward pressure on the currency.

Despite these efforts, the yuan has been slowly appreciating. It recently hit a **3.5-year high** against the dollar as Fed rate hike expectations faded. But the pace of appreciation has been far slower than what market forces alone would dictate.

### The Competitive Advantage

A weak currency gives Chinese exporters a massive competitive advantage. Their goods are cheaper in foreign markets, making them more attractive to buyers in the U.S., Europe, and elsewhere.

This isn't a subtle effect. Setser warns that China could soon be exporting **20 million cars annually**—double its current pace—or **one in every three autos sold outside the country**. The country is already dominating global markets for everything from electronics to industrial machinery.

The result is a global trade system that increasingly funnels manufacturing jobs to China while hollowing out industrial capacity in the West.

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## The Debate: To Appreciate or Not to Appreciate?

### Setser's Case: The World Can't Afford to Wait

Setser's argument is simple and urgent. The sheer scale of China's surplus is unsustainable. The global economy cannot indefinitely absorb a $1.2 trillion annual transfer of wealth from consumers in the West to manufacturers in China.

"China's export boom is bolted to a stalled economy," Setser argues. The country's domestic demand is weak, property investment has collapsed, and household consumption remains suppressed. Instead of fixing these domestic problems, China is relying on exports to prop up growth—exporting its economic imbalances to the rest of the world.

The solution, in Setser's view, is straightforward: **China needs to allow the yuan to appreciate significantly**. A stronger yuan would make Chinese exports more expensive, reducing the trade surplus. It would also increase the purchasing power of Chinese consumers, boosting domestic demand and helping China transition away from its export-dependent growth model.

Setser and fellow economist Shahin Vallée have argued that **coordinated U.S.-European tariff threats could force China's hand**. The threat of trade sanctions might be the only thing that convinces Beijing to allow the kind of currency appreciation that market forces would otherwise dictate.

### The Skeptics: Appreciation Could Make Things Worse

Not everyone agrees. A trio of prominent economists—including former IMF Chief Economist **Gita Gopinath**—has pushed back hard against the push for yuan appreciation.

Their argument is counterintuitive but powerful: **a stronger yuan could actually worsen global imbalances**.

Here's why. China is currently experiencing **deflationary pressures**. Domestic demand is weak. If the yuan appreciates, Chinese exports become more expensive, potentially reducing export volumes and further weakening the economy. This could lead to even **more** reliance on exports to maintain growth, not less.

Moreover, a stronger yuan would make imports cheaper for Chinese consumers and businesses. That sounds good in theory, but if Chinese consumers are already reluctant to spend—and they are—cheaper imports won't necessarily boost domestic consumption.

The skeptics' prescription is different: **structural reform in China** to boost domestic demand. China needs to strengthen its social safety net, reduce household savings rates, and rebalance its economy away from investment and exports toward consumption. Until that happens, currency appreciation alone won't solve the underlying problem.

### The IMF's Middle Ground

The International Monetary Fund has weighed in with a more measured assessment. The IMF estimates that the yuan is undervalued by about **8.5% to 18%**—a significant but far less dramatic figure than Setser's 30% to 35%.

But even the IMF's more conservative estimate would represent a substantial currency adjustment. And the Fund has expressed skepticism about the idea of a new "Plaza Accord"—a coordinated international effort to force yuan appreciation. The conditions that made the 1985 Plaza Accord possible—and effective—simply don't exist today.

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## The Global Impact: Who Wins and Who Loses?

### The United States

For American workers and manufacturers, a stronger yuan would be welcome news. Chinese goods would become more expensive, making U.S.-made products more competitive. This could help reverse decades of deindustrialization and bring manufacturing jobs back to the United States.

But there's a catch. A stronger yuan would also make U.S. exports to China more expensive, potentially reducing demand for American products in the world's second-largest economy. And if a stronger yuan slows China's economy, it could reduce global demand for everything from commodities to technology.

### Europe

Europe has been particularly hard hit by China's export surge. Germany, in particular, has seen its industrial base eroded by Chinese competition. Setser's "China Shock 2.0" report, co-authored with Sander Tordoir, argues that Germany's economic weakness is due in large part to pressure from Chinese industry.

Not surprisingly, some European policymakers have been among the most vocal advocates for yuan appreciation. German Chancellor Merz has claimed the yuan is "undervalued by up to 30%" and has pushed for EU action. French government advisors have similarly called for a 20% to 30% depreciation of the euro against the yuan.

### The Rest of the World

For emerging economies, China's export dominance is a double-edged sword. On one hand, cheap Chinese goods help keep inflation in check. On the other hand, Chinese competition makes it nearly impossible for developing countries to build their own manufacturing industries.

A stronger yuan would level the playing field, giving other countries a better chance to compete in global export markets. But it would also raise the cost of Chinese goods, potentially fueling inflation in countries that depend on Chinese imports.

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## The Rebalancing Question: What China Needs to Do

### Beyond Currency

Even the most ardent advocates of yuan appreciation acknowledge that currency adjustment alone won't solve the problem. China needs to rebalance its economy—a task that is easier said than done.

For decades, China's growth model has been built on three pillars: **investment, exports, and state-led industrial policy**. Domestic consumption has been deliberately suppressed through a combination of policies: a weak social safety net that encourages high household savings, restrictions on labor mobility, and a financial system that channels capital to state-owned enterprises rather than households.

Changing this model requires difficult political choices. It means strengthening the social safety net, which costs money. It means allowing wages to rise, which reduces corporate profits. It means opening the financial system, which creates risks.

### The Export Trap

There's a deeper problem: **China may be trapped in its export-dependent model**.

As one analysis put it, "weak domestic traction forces China to rely on exports, and each year of export-led growth locks the economy further into that vulnerable path". The more China relies on exports, the more it needs to keep its currency weak to maintain competitiveness. And the weaker the currency, the more exports surge—creating a vicious cycle that's difficult to break.

The Iran war exposed this vulnerability. When global demand cooled in March 2026, China's export engine "stuttered sharply," exposing the risks in Beijing's strategy of leaning on manufacturing to sustain growth.

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## The Political Dimension: A Currency Debate with Consequences

### The Trump Factor

President Trump has been notably absent from the currency debate. Some observers have suggested that a president focused on deal-making is ill-equipped to tackle the structural problem of China's surplus.

But the issue isn't going away. As Setser and others have argued, the U.S. needs to put the renminbi "back on the international agenda". Ignoring the problem won't make it disappear.

### The China Shock 2.0

Setser's "China Shock 2.0" thesis has been remarkably influential. It has encouraged EU policymakers to push for Chinese currency appreciation. It has shaped the debate in Germany, where the cost of complacency is becoming increasingly apparent.

The thesis rests on a simple observation: the rules of the global trading system have changed. The old assumption that trade benefits everyone equally has been challenged by the reality of China's state-led industrial policy. When comparative advantage is "dynamic, built by industrial policy in sectors with increasing returns and learning-by-doing," the traditional case for free trade becomes harder to make.

### What Would a Plaza Accord for China Look Like?

The 1985 Plaza Accord was a coordinated agreement among the G-5 nations to depreciate the U.S. dollar against the Japanese yen and German mark. It succeeded in revaluing the yen, though at a cost—it contributed to Japan's subsequent economic stagnation.

A "Plaza Accord for China" would involve the U.S., Europe, and possibly Japan pressuring Beijing to allow the yuan to appreciate significantly. But as Breakingviews has noted, a 25% yuan revaluation "would lift wages by a similar amount in dollar terms, but the gap would remain wide". The competitive advantage of Chinese manufacturing is about more than just currency.

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## Frequently Asked Questions (FAQs)

### 1. What is China's current trade surplus?

China's trade surplus was a record **$1.19 trillion in 2025**, up 20% from 2024. In the first two months of 2026 alone, the surplus reached **$213.62 billion**. The second quarter of 2026 saw a current account surplus of **$195.1 billion**—the largest on record for the period.

### 2. How much is the yuan undervalued?

Economists disagree on the exact figure. Former U.S. Treasury official Brad Setser estimates the yuan is **30% to 35% undervalued**. Others, including former Treasury official Mark Sobel, estimate **20% to 30%**. The International Monetary Fund puts the figure at **8.5% to 18%**.

### 3. Why does China keep its currency weak?

A weaker yuan makes Chinese exports cheaper in foreign markets, giving Chinese manufacturers a competitive advantage. The People's Bank of China actively intervenes in currency markets to prevent the yuan from appreciating too quickly, including by adjusting the foreign exchange risk reserve ratio.

### 4. What is the "China Shock 2.0" thesis?

The "China Shock 2.0" thesis, developed by Brad Setser and Sander Tordoir, argues that Germany's economic weakness is due primarily to pressure from Chinese industry. It has influenced EU policymakers to push for Chinese currency appreciation and has sparked a broader debate about China's export-driven growth model.

### 5. Would a stronger yuan help the U.S. economy?

A stronger yuan would make Chinese goods more expensive in the U.S., potentially helping American manufacturers compete. However, it could also reduce U.S. exports to China and, if it slows China's economy, reduce global demand.

### 6. What is the argument against yuan appreciation?

Some economists, including former IMF Chief Economist Gita Gopinath, argue that a stronger yuan could worsen Chinese deflation and further reduce demand for foreign goods, exacerbating global imbalances. Their prescription is structural reform in China to boost domestic demand.

### 7. What is a "Plaza Accord for China"?

A "Plaza Accord for China" would be a coordinated international effort to force China to allow the yuan to appreciate significantly, similar to the 1985 Plaza Accord that revalued the Japanese yen. Some European policymakers have called for such an agreement, but the IMF has expressed skepticism.

### 8. Can China's export-led growth continue?

China's export-led growth model faces significant challenges. The Iran war exposed its vulnerability to global demand shocks, and many economists argue that relying on exports rather than domestic consumption is unsustainable in the long term. However, China's industrial competitiveness and move up the value chain continue to drive export growth.

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## Conclusion: The Reckoning Is Coming

China's exorbitant surplus is not just an economic statistic—it's a global problem that demands a global solution.

The numbers are staggering: a $1.2 trillion annual surplus, a currency 30% undervalued, exports approaching 20 million cars a year. The world is absorbing Chinese goods at an unprecedented rate, and the imbalance is becoming unsustainable.

Brad Setser is right to sound the alarm. The world cannot indefinitely absorb a trade system that funnels manufacturing jobs to China while hollowing out industrial capacity in the West. The "China Shock 2.0" is real, and its consequences are being felt from the factory floors of Ohio to the automotive plants of Germany.

But the solution is not simple. A stronger yuan alone won't fix China's structural imbalances. The country needs to rebalance its economy, strengthen domestic demand, and reduce its reliance on exports. That requires difficult political choices—choices that Beijing has so far been unwilling to make.

The skeptics have a point: currency appreciation without structural reform could make things worse, not better. But waiting for China to reform itself while the surplus continues to grow is not a viable strategy either.

The path forward lies somewhere in between: coordinated international pressure on China to allow the yuan to appreciate, combined with a commitment to structural reform that addresses the underlying causes of the surplus. It's a difficult path, but it's the only one that offers a sustainable future for the global economy.

The debate over China's currency is not just an academic exercise. It's about jobs, wages, and the future of manufacturing in America and Europe. It's about whether the global trading system can survive the imbalances created by one country's export-driven growth model.

The reckoning is coming. The question is whether we'll be prepared for it.

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## Disclaimer

*This article is for informational and educational purposes only and does not constitute financial, investment, tax, or legal advice. All views expressed are based on publicly available information, including economic data, research reports, and commentary from economists and analysts cited in this article. Currency valuations, trade balances, and economic policies are subject to change. The views of Brad Setser and other economists mentioned are their own and do not necessarily reflect the views of the Council on Foreign Relations, the U.S. Treasury, or any other organization. Before making any financial or investment decisions based on the content of this article, please consult with qualified professionals who can evaluate your specific situation. The author is not affiliated with the Council on Foreign Relations, the International Monetary Fund, or any other entity mentioned in this article.*